20 September 2014

Emerging Markets

I recently attended a PWC seminar for Non-Executive Directors on the subject of Emerging Markets. The referendum campaign was in full swing and the opinion polls suggested it was too close to call and so I asked the organisers if they were going to include Scotland in their consideration of emerging markets. They thought it might be more appropriate to see them as a frontier market. Fortunately we can all breathe a sigh of relief now but the constitutional crisis that has been stirred up by these cack handed politicians may well still spook the markets.

PWC joined forces with Eurasia Group, a leading political risk consultancy, to present their views. Eurasia Group thinks it’s going to be a bumpy ride over the next five years and we need a new road map. After Jim O’Neill of Goldman Sachs coined the acronym BRICS, suggesting the most interesting emerging markets would be Brazil, Russia, India, China and South Africa, every other tin pot analyst has tried to come up with an equally catchy acronym. We’ve had the following:

MINTS: Malaysia, Indonesia, New Zealand, Thailand, Singapore

CIVETS: Columbia, Indonesia, Vietnam, Egypt, Turkey, South Africa

MIST: Mexico, Indonesia, South Korea, Turkey

TIMPS: Turkey, Indonesia, Mexico, Philippines

But this just becomes a lazy way of looking at the next emerging markets. Mr O’Neill himself admits that he was just underlining the potential of countries with large populations. In any case the rate of growth of the BRICS has slowed and all boats are no longer rising.

Eurasia thinks we should reconsider the way emerging markets interplay with global forces as increasingly the G7 demonstrate their inability to manage these. Each emerging market has its own set of unique characteristics that interact with these forces to create divergent trajectories. Understanding this divergence and how it impacts a firm’s business drivers is a prerequisite for sound investment decisions.

For example, a lower growth rate creates greater trade-offs in economic policy. As the middle classes grow they focus on demanding better services and start to react against the polarising national leaders. The poorer classes continue to pose greater demands for social justice. As Brazil has got richer more people have felt secure in their employment and instead focus on quality of life issues such as healthcare, transportation, crime and education. Their time horizons stretch as they seek better education for their children. This presents a challenge for political leaders who, as the rates of growth slow, should be tightening their spending but instead come under pressure to increase it.

Eurasia plots the rate of incumbency of political leaders. Those who have survived longer have a better chance of keeping their jobs even in crisis as there is an electoral bias to the long-serving incumbents. 2014 has the heaviest electoral calendar in emerging markets since 2007 with elections still to come in Egypt, Brazil, Mozambique, Uruguay, Lebanon, Namibia, Romania, Bolivia and Tunisia. Eurasia’s model shows that where the incumbent’s approval rating lies between 40% and 60% he will win 85% of elections. Unfortunately this tends to lead to weaker second terms with a lack of reform and reluctance to tackle bottlenecks in the supply chain thus hampering growth. In all there will have been 44 elections in emerging markets in 2014 and in only a handful will there have been a change of government.

So in a few countries we may expect movement in the right direction where there are high political capital, institutionalised political systems and fewer security vulnerabilities. These countries will make overtures to the private sector as we are seeing in Columbia, India, Mexico and the Philippines. (CIMPs anyone?) In other countries where there are less institutionalised political systems and politics is becoming more polarised the downside risks will grow as we can see in Turkey, Russia, Argentina and Venezuela. (TRAVs perhaps?)

For the private sector this means that those businesses that can align their strengths with the rise in the middle classes have the best opportunities. Ask yourself how your sector is aligned with the middle class demands for improved services and healthcare etc and this will inform your strategy.

PWC also looked at the macro picture pointing out that the IMF forecasts 24 countries to grow at 7% or more in 2015. They are all in Africa or Asia. But there is nothing monolithic about this group and we have seen one of the BRICS, Brazil, slip into recession while there is considerable volatility in currencies and commodities. Investments can differ, of course, and we were shown two headlines from the Financial Times: the first said “Argentine default triggers swaps payout” while 24 hours later the second said “Hedge funds bet on Argentine recovery by piling into stocks”.

They then warned us of the risks associated with the political landscape and regulatory governance. Even with the rise of emerging markets in recent years there is considerable uncertainty over governance, policy-making and tax legislation. There can be renegotiation of royalties in extractive industries and worse, the risk of expropriation or nationalisation.

A particular warning was made over rules relating to local content, infrastructure and capacity. Many countries stipulate that Foreign Direct Investment is accompanied by an investment in the local market. This is seen as a way of transferring skills from foreign investors to the local population. For example, Angola requires that 70% of a workforce should be local employees. This may be fine in a sector such as the extractive industries where primarily physical labour is needed. But if it is a service industry requiring a minimum level of education then in sub-Saharan Africa the secondary school enrolment rate has only reached 40% of the population and was only 20% back in 1980.

Then there is the continuing problem of corruption. It is clear that corruption is a higher risk in emerging markets compared to developed economies. According to Transparency International’s 2013 Corruption Perception Index, while most of the G7 are in the top twenty with only France and Italy below that at 22nd and 68th respectively, the BRICS are at 72nd (Brazil), 80th (China), 94th (India) and a woeful 127th (Russia). We now need to take account of the UK Bribery Act which may set the highest standard of any country. Here again there is no set way. Patterns and levels of corruption vary by country and sector. Investors benefit from robust anti-corruption policies and procedures. A particular danger may lie in countries that require that a joint venture be set up with a local partner. But who is that partner? He may well turn out to be the brother of the minister or official responsible for licensing the JV.

In summary we can see that emerging markets are at a real turning point. The new political cycle and demands of the middle classes will provide new opportunities as well as presenting interesting challenges. The drivers of investment decisions are likely to be different going forward compared to the past ten years. Emerging markets all have different characteristics and require individual consideration. And finally proper due consideration is vital.

As someone who did a course in Foreign Market Entry Strategies at the Wharton School of Economics over thirty years ago I found most of these points obvious. The observations on the current political and economic landscape were interesting and I would agree that the next few years may see increasing volatility. I still have my papers from that course with 201 checklists for decision making in international operations and I have used many of them if not all while transacting business in nearly 50 countries. Above all that has taught me to treat each one on its own merits and not draw conclusions from geographic proximity or sharing a language or any other short cut to understanding.

For what it’s worth here are some views of Eurasia on specific markets[i]. I have italicised those that appear inconsistent.